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Hayek on the Large Corporation (aka “Breaking up Big Banks?”)

December 15, 2011

by Mario Rizzo

For those who enjoy trying to figure out what important thinkers might have thought about specific issues they never faced (and I am one of them!), the following letter I discovered will prove interesting and perhaps disconcerting to some.

Below is a brief excerpt from a letter that F.A. Hayek wrote to the journalist and political theorist Walter Lippmann in 1937.* The subject was the large modern corporation which Lippmann thought was prone to developing various degrees of monopoly power. This was a view shared by Frank H. Knight at this time, and Hayek may have agreed, at least to some extent.

The issues were: (1) Why was this the case? and (2) Was it consistent with (classical) liberalism for the government to do something about it?

Hayek was not sure about the causal factors contributing to the large size of corporations. Therefore, he was reluctant to jump to the conclusion that, as advocated by Lippmann, the rights of corporations to grow beyond a certain size — by reinvesting retained earnings — should be limited.

Nevertheless, Hayek believed that the precise contours of property and contract rights were not fixed for all time. Therefore, while the rule of law necessititated each of these realms of rights, it did not rule out all changes.

Hayek’s critical words are:

“But the whole matter is one of extreme complexity and difficulty, and I cannot say, that I have definitely made up my mind. My main doubt is whether it really is the corporate law which has given rise to corporations bigger than they would become under the . . . free market, or whether it is not largely the greater influence on the political machine, which the great corporation exerts, which has favoured its growth.”

In the first place, it must be pointed out that “corporate law” is not simply the exercise of contract and property rights among natural persons. The reason for this is that the corporate form is a legislatively constructed form of individual interaction. Most obviously, it is a form with limited liability and special tax treatment, among other things. So the growth of corporate entities is not independent of its specific legislated form.

More interestingly, Hayek recognized the political-influence character of corporations.

Fast forward to today’s world and to the issue of big banks as “too-large-to-fail” entities. I do not think Hayek would have been altogether shocked by the Venn diagram of political influence I posted recently.

Therefore, I suggest that Hayek today would be open to curbing the growth of banks in a world permeated by moral hazard. The expected and actual political insurance of losses is not only a factor in the current size of banks, but it is a threat to the stability of the monetary system.

Somehow we need to return to a situation where the private bearing of losses and the potential failure of big banks is a real possibility. One bad alternative is to micro-manage the behavior of banks. This, in the long run, is a loser — because of continual financial innovation and the capture of the regulators by the regulated. This alternative also will no doubt violate basic principles of the rule of law as the regulators are given wide discretion to do “good.” [Read Dodd-Frank.]

Another alternative is to simply let the big banks fail. If I could be convinced (and I am not) that there are no large systemic risk dangers, I would say let them fail. (The oft-touted alternative of applying bankruptcy law to banks may not work as those who know more about this than I have said.)

So there we are: To preserve the rule of law, in the very nasty and imperfect world in which we live, we may have to do the previously-unthinkable.

Yet before people react to such a suggestion as a violation of contract and property rights, it is important to recognize that these rights have been exercised in a legislatively constructed context that had only a pragmatic justification. The politicization of the banks has made their growth, as well as their impact on the economy, not a feature of the free market.

Classical liberals must be willing to distinguish berween crony capitalism and the free market. If not, the free market is doomed.

(*The letter appears in Ben Jackson, “Freedom, the Common Good and the Rule of Law: Lippmann and Hayek on Economic Planning,” Journal of the History of Ideas, 73 (2012), forthcoming. Unfortunately, I am not at liberty to provide a link to the manuscript.)

18 Responses to “Hayek on the Large Corporation (aka “Breaking up Big Banks?”)”

It’s a powerful argument except that … “curbing the growth of banks in a world permeated by moral hazard” (as you write) will be subject to moral hazard. I can’t imagine how politicians and government bureaucrats will break up companies with trillions of dollars in assets, with all the opportunities that will offer, without corruption in one form or another.

Mario raises an important issue. Some view the modern corporation as almost entirely a creation of legislation. Others have argued that the modern corproation evolved naturally over centuries.

Obviously, the form the modern corporation has taken has been influenced by statutes. Banks operate as privilged institutions and are a special case.

Do corporations have influence on politics because of their corporate form, or the amount of the wealth they control? Were the Morgans less politically influential when their banks were partnerships?

Modern corproations may have privileges, but the corporate form is an efficient way of aggregating capital. The possibility of having many small owners who can easily dispose of their shares is surely a factor in the growth of public corporations.

I don’t see corporations as merely a state construct that wouldn’t exist without the state. I would bet that courts have always given lenders limited liability as long as they did not exercise control over operations. We don’t need laws giving lenders limited liability because it’s just common sense that if someone doesn’t exercise control over operations they shouldn’t be held liable for mistakes.

So limited liability shouldn’t be an issue with equity and corporations. All that stock ownership does is to take away the fixed rate of return. We can separate ownership and stocks. So it would be possible for a large sole proprietorship to issue stock-like security just as corporations issue bonds and the stock holders retain limited liability. The stock would guarantee the holder a share in the profits but without any ownership claims. In that case, the sole proprietor would carry all of the risk. But would that limit the size of firms?

So I think the issue becomes what causes firms to grow so large? Is it the corporate structure or the ease of raising money via stock sales? Keep in mind that the corporate bond market is far larger than the stock market. So I’m guessing the problem isn’t the limited liability associated with stock ownership. Sole proprietorships could probably grow as large using nothing but debt. If size is the issue, I doubt getting rid of corporations will do anything to keep businesses small.

As for banks, all that is needed to keep them in line is private deposit insurance. If depositors had to buy their own insurance to protect their deposits, insurance premiums would guide them to the safest banks. And if banks bought insurance from private companies, premiums would force them to be more conservative. The biggest problem with the current system is FDIC. It causes moral hazards coming and going.

Banks are special because of fractional reserve banking. The large the bank the more it can get away with smaller reserves. So as long as fractional banking exists there may need to be a limit on size. That doesn’t apply to non-bank businesses.

Just because government defends private property and enforces contracts does not mean that these institutions are no more than political creations. Similarly with corporations, for which the enabling legislation may reasonably be regarded as implementing and facilitating people’s liberty to pool resources for common purposes. Any legislation to coercively limit the size of — and effectively thereby penalize — successful enterprises ought to be considered in that light.

Nor is micromanagement the only alternative. Private deposit insurance might protect individual deposits, as Roger McKinney points out, and depositors with a lot to lose might reasonably divide their liquid assets among several banks. Where’s caveat emptor? But if I understand correctly, the biggest problem might be the disruption of the payments system if outstanding checks cannot be cleared. To minimize such disruption, banks themselves might be required to maintain separate funds or reserves or insurance sufficient to allow the transaction to be completed. That’s no more objectionable than requiring drivers to maintain liability insurance.

That’s a really interesting question, the role of corporate law in the emergence of systemically important institutions. I’m thinking a Cantillon effect might also be a big part of the explanation.

Still, the “break-up big banks” argument implicitly assumes that the financial sector propagation mechanism of systemic risk is counterparty contagion, which might not be the case. Empirical literature likely suggests that contagion is in fact informational. That is, contagion spreads because the financial difficulties of the initial bankrupt firm revealed information on a risk shared by the initial and subsequent bankrupt firms. Having smaller banks may make their bankruptcies more bearable politically, but it might not reduce systemic risk and its threat on the system of payments (assuming the threat of systemic risk is real). In a world devoid of big banks but with a systemic risk threat still present, I’m not convinced there would be significantly less cronyism.

Squawk Box on CNBC this morning compared the MF Global fiasco to banking. I can’t remember who the guest was be he is a banker. He and all of the SB staff saw the clear linkages between futures brokers and fractional banking. All futures brokers invest their customers’ margin accounts without the customer knowing it and without paying interest on the borrowed funds. Traditionally the brokers had invested in government securities but over the last decade they invested in southern European government debt, which was a fiasco. The most interesting part was when the banker and FTC chairman tried to defend fractional banking while condemning the practice of the brokers. The staff of CNBC could clearly see the hypocrisy.

First, there is a misconception regarding the size of US banks. The US banking system is already the most fragmented amongst developed nations. In this regard, it may be illustrative to note that despite the US having the largest economy and financial sysem in the world BY FAR, no US bank is amongst the top 5 largest in the world, and only three US banks are amonst the top 20.

Second, in a free market the size of institutions will tend to be determined by efficiencies gained through economies of scale and scope. There are large economies of scale and scope to be gained in the financial industry. On can empirically observe that this is one reason that financial institutions have grown to be so large around the world. It can also be empirically observed that US financial institutions have historically been limited in their size only due restrictive legislation such as Glass-Steagall and myrriad other laws and regulations at the national and state levels. Arbitrarily limiting the size of US financial institutions any further would necessarily hobble their global competitiveness.

Third, I believe that the idea that the notion that “too big to fail” had anything to do with the US financial crisis of 2008-2009 is a myth. The crisis was SYSTEMIC. It had its origins in a mania that affected small and large banks alike. There is absolutely no empirical evidence nor any credible theoretical evidence to suggest that smaller banks make less risky decisions or are less prone to systemic risks. Quite to the contrary. Smaller institutions, in general, have higher risk profiles. It is also far costlier to for society supervise them properly and to sort out the mess when they go bust.

Banks were not bailed out in the US because they were so big and/or politically powerful. They were bailed out because no nation can afford to allow its entire banking system to collapse. In a systemic crisis all banks will be at risk simultaneously, whether they all be large or small. Either way, the state will intervene in a systemic crisis.

The effort to arbitrarily restrain the size of banks will only shift the problem from one of “too big to fail” to one of “too many to fail.”

From the creation of the very first bank, banks have existed to take away the power to decide what you want to do with your wealth and give it to the government. (The Bank of England was created in 1694 to provide King William with funds to conduct a war). As a creation of the state, they are always going to be subject to political influence. Governments should be constitutionally banned from borrowing from all but real living persons except in times of war.

There are a variety of ways to measure the size of banks (assets, deposits, market capitalization,etc.). The measures produce substantially different lists. Measured by assets, the top 5 comprise a number of banks showing up on lists of problem banks.

Measured by capitalization, there are 3 US banks in the top 10. In any case, the whole argument is irrlevant.

“Too big to fail,” moral hazard and government/bank entanglements may be worse elsewhere. It doesn’t diminish the problem in the US. Moreover, post DFA, the trend is upwards.

As Murray Rothbard pointed-out in Man Economy and State, Walter Lippman was well known for his idea that limited liability is the source of undue Corporate Power. von Hayek’s response was perfect! Of course, it is the influence of big business on the State, not the Corporate organization itself that is the problem. Remembering that ANYONE can form a Corporation with limited liability for $100.00 or so should answer the issue!

Also important to recall that the great Investment Banks surrounding the Bank of England and the Federal Reserve were, until recently, unincorporated! This did not prevent them from amassing all manner of undue privileges from GOVERNMENT!

Originally, Corporations were Chartered one by one for special purposes of State. In spite of their private ownership, they were instruments of the State. Contrary to the LEFT, Considering Corporations as “individuals” was a great step forward away from Statism. . . expanding the privilege of limited liability to one and all (and their legitimate private interests), instead of just the King or Parliament!

Bond holders have limited liability as much as owners of stock and the bond market is far larger than the stock market. So I don’t think limited liability for stock owners is much of an issue. I would guess that corporations can grow larger than private companies because they can attract more money, and they can attract more money because of transparency. Transparency makes it easier for investors to decide whether to buy stock/bonds from a corporation or not and transparency makes it easier to sell corporate bonds/stocks, thus making the investment more liquid.

You could eliminate the corporate structure and allow private businesses to issue stock. The stock would carry no rights to elect a board of directors but would allow participation in profits. If the private companies were required to publish financial statements like corporations, the transparency would make their stocks/bonds more liquid and thus more attractive.

So I think the main advantage that corporations have is the transparency they offer investors.

A couple of thoughts come to mind in response to your post. First, on Hayek, another essay that bears directly on this subject is (of course?) ”Free’ Enterprise and Competitive Order’, in which he argues that the classical liberals failed to propagate their ideas down through to the present because they too often neglected the distinction between, and tension between, the law of property and the principles of private property.

Two points in that essay that stuck out to me in the connection to this post. First, his point, reminiscent of Bagehot on central banking, that though a liberal might justifiably disapprove of the existence of a formal institution (a law), problems in political economy arise given that it does exist. It is a point about second-best institutions.

Second, Hayek cites approvingly JS Mill, in a passage that claims that the evolution of property law went in a direction contrary to the principles of a competitive order, the result of this evolution being a tendency to the concentration of wealth (1948: 110).

Oh, and a third point of interest relevant to the subject of political influence in money and banking is the discussion of the discretion of central banks (p. 112). The question he raises only in passing is to what extent this discretion can be limited. Political central banks exist; how can they made to conform more with the principles of a competitive order?

Stepping out from the history of thought, and looking more directly at the issue-at-hand, I wonder what are the ‘bright lines’ that separate ‘too big to be politically neutered’ from all other financial intermediaries…?

Also, I wonder about the possible connections between trade associations established to provide mutually various services and to defend their members’ interests from political intervention, on the one hand; and the state of the world in which the trade association is some combination of rent-seeking and object of rent-extraction (depending on the circumstances).